As young parents, it is often tough to have access to a lot of cash when you need it. And boy are there times when you need it! An unexpected bill comes up. You have too much credit card debt? You want to buy a house? Unexpected medical expenses for your kids or for your parents. The list goes on and on. One of the sources of easy cash to which you have access is your 401k. You ask yourself, “Should I take out a 401k loan?”
Should I Take Out A 401k Loan
The answer is yes, no, and maybe. I know that sounds like a politician’s answer, but read on. There are three major reasons you may want to take out a 401k loan. First is to pay off a bill or debt. Second is to invest or buy an asset. Third is to buy a house.
- Using a 401k Loan to Pay a Bill or Pay Off Debit is Bad – The holy grail of all savings is your retirement fund and this should be your highest priority throughout most of your life. You are going to need a lot of money in retirement and it will take a long time to save for it. You should exhaust all other resources before going down this path. Tip: If you feel you have to use a 401k loan to pay off debt, ensure that debt can never return to haunt you. For example, if you are using it to pay off credit card debt then you need to cut up your credit cards (all of them) AND call and cancel them.
- Using a 401k Loan to Invest or Buy an Asset is Strategic – Let me first define what an asset is. Like in the book, Rich Dad Poor Dad, I define an asset as something that will make you money. What are some assets that can make you money? The two most obvious are buying rental property or buying/starting a business. I commute to work and am in the car for two and half hours every day. Let’s say I wanted to move closer to my job. If I sold my current home, I would not make enough money from it to make it worth my effort. My mortgage option would be a 401k loan. After crunching the numbers, I discovered that I would have $100,000 less in my retirement fund by taking out a loan. However, I would generate more than $600,000 in rental income before retirement and $40,000 a year during retirement in rental income. That more than makes up for the $100,000 loss. On top of that, I would have an assets worth $630,000 at retirement. (p.s. After seeing these numbers, I just bought a book on rental property).
- Using a 401k Loan to Buy a House is iffy – Note that I do not consider a house, at least your primary residence, an asset. Why? Because your house does not generate any income for you. In fact, it is a liability because it costs you money – even after it is paid in full (property taxes, maintenance, insurance, etc). Because of this, a 401k loan should not be your first source of funds for a down payment. And do NOT tap it just so you can afford a larger house. However, I understand how home ownership instills a since of accomplishment and security and that is why I call this one iffy.
How do 401k Loans Work
I’m only going to give you a brief overview on how 401k loans work today. If you would like more information, you can visit the 401k Help Center.
- In most cases, you will take out a 401k loan directly from your provider – not through your employer.
- You must be currently employed by your employer who sponsors the 401k plan. If you leave your job or are terminated prior to paying your loan back, the entire amount of the loan will be due almost immediately.
- In most cases you apply for the loan online. You select the reason for the loan (buying a house or other), the amount you want to borrow (up to half of your current balance). If you are borrowing for a down payment on your home, you can repay the loan over a longer period of time (5+ years). If you are borrowing for any other reason, your repayment term will be shorter (less than 5 years).
- Your credit will not be checked and you will receive the funds quickly.
- You pay your loan back through your paycheck contributions. The interest paid on the loan is paid to yourself, so you still earn money on your 401k loan funds. Once the terms are determined on the loan, they cannot be changed. For example, if you say you will pay the loan back in 2 years, you cannot change the terms and pay it back in 4 years.
Will you take out a 401k Loan?
Taking out a 401k loan is one of the toughest decisions you will ever had to make. You are not alone in this decision. According to a National Bureau of Economic Research, traditionally between 25% and 30% of 401k participants have taken out a 4o1k loan. I ask you not to make this decision lightly. Instead, take time, conduct research and crunch the numbers to see how a 401k loan might affect you.
Have you ever taken out a 401k loan? If so, please share your experience int he comments section below.